Reining in Wall Street

The more complex the investment, the more profit for the derivatives dealer, says Warren Buffett. Photo / Bloomberg

Corowa Shire, a three-hour drive from Melbourne, couldn't be farther from Wall St.

That didn't stop the local council, which represents about 11,000 people, from investing A$1 million ($1.24 million) in one of the most esoteric inventions cooked up by the financial industry, a constant proportion debt obligation, or CPDO, with the catchy name "Rembrandt". The top-rated note, linked to credit-default swaps on investment-grade companies, lost 93 per cent of its value in two years.

"How do you have an AAA-rated instrument go belly up as quickly as that one did?" asks Ian Rich, director of corporate services for the council, which is suing its financial adviser, Local Government Financial Services, over the losses. "We're very straightforward now in our investments. We're really only investing in term deposits with major banks."

Wall Street's penchant for concocting opaque products - investments that lacked real-time pricing data and were so complex they could only be created and analysed using computer models - played an important role in the worst financial crisis since the Great Depression, and one that regulatory reform proposals will struggle to curtail. While banks say they're meeting demand from investors for higher returns, critics say it's time to rein in instruments that confuse buyers, carry hidden risks and whose main purpose is generating fees.

"I don't think it's the job of the financial community to bewilder its clients," says Nicholas Brady, who served as US Treasury Secretary under former President George H.W. Bush. "They were making so much money they just wanted to keep the bewilderment machine churning."

A community like Corowa never had a chance of understanding what it bought. Even if it had a model, "you really had to spend months and months playing with it and understanding exactly all of the moving parts to be able to see where the failings were," says David Watts, a London-based strategist at CreditSights, who was an early sceptic about the notes.

Over the past decade the financial industry justified the rapid growth in products such as CPDOs, collateralised debt obligations and credit-default swaps by arguing that they were sold to qualified investors who understood the risks and were able to bear them. Their view was echoed in July 1998 Senate testimony by then-Federal Reserve chairman Alan Greenspan, who said "regulation of derivatives transactions that are privately negotiated by professionals is unnecessary".

A decade later his assessment was proven wrong when some of the industry's most sophisticated participants, including Citigroup and American International Group, were bailed out of bad bets on contracts whose risks they underestimated. By using government funds and cutting interest rates, politicians and central bankers laid the cost on taxpayers, savers and people on fixed incomes.

Now the US Congress and policymakers around the world are considering ways to make the financial system safer. New rules aim to force privately negotiated derivatives - contracts whose value is tied to securities or specific events such as changes in interest rates or the weather - on to exchanges or clearing houses, where investors would have more information about prices. Banks would also be required to hold more capital against instruments deemed too complicated to trade openly.

The US Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority and the Basel Committee on Banking Supervision are considering proposals that would limit the risks from some complex products, and curb their growth.

The stakes for Wall Street are high. Its profit growth in recent decades has depended on an ability to devise new and increasingly opaque products.

As competition and technology eroded margins from selling stocks and bonds, the outstanding notional value of over-the-counter derivatives climbed to US$614.7 trillion ($868.2 trillion) at the end of 2009 from US$88.2 trillion 10 years earlier, according to the Bank for International Settlements. That's more than 10 times the world's annual gross domestic product.

Over the same period, financial-industry profits in the US surged to US$414.1 billion, or 36 per cent of all domestic corporate profits, from US$224.9 billion, or 29 per cent, according to US Commerce Department data.

"The more complex, generally speaking, the more profit there's going to be for the derivatives dealer," billionaire investor Warren Buffett told the US Financial Crisis Inquiry Commission this month. Once, trading stocks listed on exchanges was a lucrative business for Wall Street. That changed on May 1, 1975, when regulators abolished fixed commissions and opened the markets to price competition. The move accelerated brokers' efforts to create more complicated, less commoditised investments.

One avenue was through private placements, a way for companies to raise funds by selling unregistered securities to accredited buyers with limited disclosure.

In 1990 SEC rule changes made the offerings more appealing to institutional buyers, and allowed firms to sell securities to foreign buyers without registering them in the US. "There was a feeling that the commission had been tight-fisted with the rules before then and that the markets were sophisticated enough for people to analyse these private offerings," says David Martin, head of the SEC's corporate finance division from 2000 to 2002.

The rule changes opened the door to a proliferation of products traded outside public exchanges, including junk bonds and asset-backed securities. When the economy soured in 2001, one company that took a hit was American Express' financial advisers unit. It recognised about US$1 billion in pretax losses in the first half of the year from junk bonds and CDOs made up of junk bonds.

However Wall St created even more complicated products, such as CDOs that bundled pieces of other CDOs or credit-default swaps. In the case of Abacus - a synthetic collateralised debt obligation that is now at the centre of a lawsuit brought by the SEC against Goldman Sachs - the pool was made up of credit-default swaps on 90 residential mortgage-backed securities. Each of the 90 securities contained thousands of loans and was described in a prospectus that ran to hundreds of pages. A one-page diagram of the structure in the document showed 13 boxes connected by 14 arrows.

Goldman Sachs, the most profitable securities firm in Wall St history, is also being sued by Australian hedge-fund company Basis Capital over another synthetic CDO known as Timberwolf. Basis says Goldman Sachs benefited from the market's opacity and that the investment bank, whose internal emails showed an executive called the deal "shitty" the same week Basis was completing its purchase, hoped to profit from a bet against it.

Goldman Sachs argues that Basis made its investment at market levels it deemed attractive, that the fund had agreed not to rely on Goldman Sachs and that Goldman Sachs had itself lost "several hundred million dollars" on Timberwolf securities.

Investors were tempted into such purchases because they promised the same low risk as owning high-quality debt like US government bonds, with better returns. That enabled fund managers to beat AAA-rated benchmark indexes, says Satyajit Das, a Sydney-based former derivatives banker at Citigroup and Merrill Lynch, and author of Traders, Guns & Money. "If you're going to sell somebody any structure - I learned this 25 years ago - you don't really need to talk about the product," Das says. "You simply need to say: 'Your index is this, and if you do this over the next quarter or two quarters, you're going to beat the index by X."'

It wasn't only the clients who couldn't resist the promise of boosting returns without adding risk. Financial companies including Citigroup, Merrill Lynch and Zurich-based UBS also lost billions after buying and holding onto the AAA-rated portions of CDO debt.

The bets soured when mortgage-backed securities underlying the deals declined in value after defaults on sub-prime home loans made to unqualified borrowers prompted downgrades of the debt. Only a few market participants saw the trouble brewing, including Goldman Sachs, whose executives began looking for ways to bet against securities tied to sub-prime debt in late 2006.

"Banks should be limited in how many of each instrument they're allowed to trade," says Paul Wilmott, a London-based author and quantitative-finance instructor who has also been a critic of the industry's over-reliance on mathematics and statistics. "Otherwise it's dangerous, and it's not just dangerous to your bank and your clients, it's dangerous to innocent people as well."

That's what residents of Corowa Shire discovered after November 2006, when their local council bought Rembrandt CPDO notes issued by Dutch bank ABN Amro Holding. ABN Amro created the first CPDO earlier that year, an AAA-rated note called Surf yielding twice the rate of other bonds that were barely investment grade. It did this by selling credit-default swaps on two indexes of 250 North American and European companies with investment-grade ratings. Credit-default swaps act like insurance because the seller collects premiums in exchange for promising to pay the buyer if the reference securities - in this case corporate bonds underlying the index - suffer losses or a default.

The Rembrandt CPDO offered investors AAA-rated notes that paid 1.9 percentage points above Australia's three-month bank-bill swap rate, or about 8.25 per cent at the time, says a suit brought by 10 councils in Australia's federal court against Local Government Financial Services (LGFS).

In turn, LGFS is suing ABN Amro and ratings company Standard & Poor's, asserting that it was misled. In a defence document, ABN Amro denies it engaged in any misleading or deceptive conduct and says LGFS had "sole responsibility" for determining whether the Rembrandt notes were appropriate investments. Frank Briamonte, a spokesman for McGraw-Hill, which owns S&P, says the claim is "without legal or factual merit, and we will defend ourselves vigorously against it".

The Dutch bank wasn't alone in selling CPDOs. From 2006 to 2007, firms including UBS, JPMorgan Chase and Lehman Brothers created their own notes, selling more than US$4 billion of them to investors in six currencies, according to data compiled by CreditSights.

By the end of 2008 the securities were all but worthless. Banks, hedge funds, insurance companies and other fixed-income asset managers rushed to buy default protection through the derivatives indexes underlying the CPDOs, sending the cost of the indexes to record highs and deflating the value of the notes. The Australian councils that bought Rembrandt received less than 7 cents on the dollar.

The CPDOs were the "most egregious example of this wave of financial innovation, but it's different in degree not really in kind", says Frank Partnoy, a professor at the University of San Diego School of Law, former derivatives trader and author of Infectious Greed: How Deceit and Risk Corrupted the Financial Markets. "Most financial innovations benefit Wall St banks, not the ultimate savers or borrowers."

This week US lawmakers continued negotiating over reform legislation that aims to prevent a future financial calamity, including limiting the risks created by complex, hard-to-value instruments.

The legislation would bring most of the over-the-counter derivatives market under regulation for the first time, requiring the most actively traded contracts to be moved through central clearing houses and traded over regulated platforms that would increase price transparency.

For derivatives that are too complex to be cleared, regulators will require dealers and major market participants to hold "substantially higher" capital against the trades, according to a bill approved by the Senate that is now being reconciled with one passed by the House of Representatives.

Revised bank capital guidelines agreed to by the Basel committee last year, which could be implemented by the end of 2011, will increase how much capital banks must hold against securitised assets, especially those that repackage the assets.

"It's going to severely deter that whole business," says David Kelly, a former counterparty credit-risk manager at Citigroup who is now director of credit-product development at derivatives-valuation firm Quantifi in New Jersey.

But some industry veterans doubt that the proposed laws and regulations will make a significant difference. Richard Breeden, who led the SEC from 1989 to 1993, said at a conference in Washington this month that new rules won't matter unless regulators gain the courage to make banks smaller and less profitable. Alan "Ace" Greenberg, the 82-year-old former chairman of Bear Stearns, says he doesn't expect regulation to damage the industry.

"I really don't," says Greenberg, who has worked on Wall St since 1949. "Regulation never hurt our business."

While CPDOs survived only briefly, other complex products continue to thrive after the financial crisis. One area that's still growing is structured products, registered securities that combine features of bonds and derivatives and are sold in small, illiquid batches, often to retail investors.

Sales of structured products to US retail investors may set a record this year, with US$21.5 billion sold by June 8, according to StructuredRetailProducts.com, a database used by the industry. "Even investors that got burned are back buying these things," says Marilyn Cohen, president of Envision Capital Management in Los Angeles. "They're like little cancers in finance."

Proponents of the notes argue that they're registered securities with full disclosure and that they offer buyers tailored bets they couldn't get elsewhere. John C. Bogle, the 81-year-old founder of the Vanguard Group of mutual funds who has argued for tougher financial oversight, says investors have been fooled into believing they benefit from Wall St innovations rather than bear the cost.

"The financial system subtracts value from society," says Bogle. "Wall St represents a cost that takes away from the proven long-term returns available in the market. That's the reality."

- BLOOMBERG